US equities portfolio managers Doug Rao and Nick Schommer discuss why they believe it is important to balance near-term optimism for equities in 2020 with a focus on long-term themes.
- A trade truce between the US and China has provided near-term optimism, which could
boost earnings growth in 2020 as global supply chains are refilled.
- The global economy still faces structural headwinds that will likely challenge economic
growth over the long term. In this environment, it is imperative to identify businesses that
can generate organic growth regardless of the macroeconomic backdrop.
- Further equity market volatility is likely as the US election cycle unfolds.
Though equity markets finished 2019 strongly, the trade war between the US and China created uncertainty that stunted the growth globally. Clearly, it is hard to realise growth potential with daily headlines and rhetoric that, if fully implemented, would cause dramatic changes in input costs. However, toward the end of 2019, the countries came to a limited trade truce, a step that we believe could help to revive global supply chains and in turn boost earnings growth in 2020. If the adage that stocks follow earnings holds true, we could see a positive market impact from earnings improvement.
Against this backdrop, we believe growth equities look relatively attractive. The Russell 1000 Growth Index[i], a benchmark for US large-cap growth stocks, finished calendar-year 2019 with a gain of 36.4% (in US dollar terms), along with significant price-to-earnings (P/E) expansion. But this performance came on the heels of a lackluster 2018, when the Russell 1000 Growth Index fell 1.5% and P/E multiples consolidated sharply. Looking over the past two years, the index delivered a cumulative return of 34.3%, or 15.9% annualised, making the outsized gains of 2019 more palatable.
Global growth challenges
We are mindful of short-term fluctuations that affect market sentiment, but we find it far more relevant to look at trends unfolding in 2020 that could have a longer-term impact on global economic growth. Although China and the US have reached the first stage of a trade deal, the relationship between the two superpowers remains complex and is far from resolved. We believe we have entered a technology cold war and see evidence of supply chains separating between companies as the two superpowers decouple their technology economies. The ongoing dispute could create inefficiencies and hinder innovation, slowing growth potential.
Politically, the Western world is grappling with a surge in populist sentiment, as a large percentage of the population feels that the system doesn’t work for them. We have seen this in Brexit, with political candidates on both sides of the aisle in the US, in Germany and in other developed Western countries. This populist sentiment could be another constraint, potentially fostering instability and opposition to pro-growth policies, which could have a broad impact on companies and industries.
Structural issues, like an ageing global population and burdensome levels of debt worldwide, could also constrain future growth. In the years to come, the global economy will have to grapple with a smaller working-age population, debt that must be repayed at the expense of stimulative investment and stagnation from increased savings rates. To offset these headwinds, we believe global growth will be increasingly tied to secular themes and that investors will need to selectively identify companies with exposure to these areas in order to potentially repeat (or get anywhere near) the kinds of returns we saw in 2019.
What are these themes? They include trends that we have long discussed: the economy’s digital transformation, the transition to the cloud, the shift from physical to digital payments and idiosyncratic innovation in specific companies in the healthcare industry. We also see the evolution of companies into direct-to-consumer businesses, creating digital connections with customers and a valuable feedback loop that builds trust. The proliferation of semiconductor content through the industrial economy should also continue. This powerful theme can be seen as technology becomes omnipresent in our everyday lives, in products like the ‘Ring’ doorbell, as well as active safety features in cars such as lane change assist capabilities.
In a world where demographics, rising debt levels and political upheaval threaten macroeconomic growth, we believe it is especially important to focus on fundamental investing, and identify individual companies that can generate their own growth. There will be winners and losers as companies face these evolutions. In our view, the winners will be those firms that are positioned to benefit from powerful, disruptive themes. We believe these – not short-term events – are the true factors impacting company fundamentals. For this reason, we think it is imperative for investors to focus on companies that have durable franchises with the ability to grow market share and expand their businesses – in short, wide-moat companies that have built sustainable competitive advantages. In doing so, we believe investors will be well positioned for not only 2020 but the long term as well.
[i] The Russell 1000® Growth Index reflects the performance of US large-cap equities with higher price-to-book ratios and higher forecasted growth values. An index is unmanaged and not available for direct investment.